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Guns Won't Give Investors Butter

By Robert Friedman, CPA In the wake of press reports that the Pentagon may be facing $30 billion in budget cuts over the next six years, defense stocks took a beating on Jan. 4. We at Standard & Poor's Equity Research Services are maintaining our negative outlook on the group, based on industry fundamentals and valuation.

These stocks are part of the broader S&P Aerospace & Defense index, which had a good run in 2004, rising 16%, vs. a 9% advance for the S&P 1500 index. While the increase was primarily driven by a sharp rise in commercial contractor Boeing (BA

; S&P investment rank 3 STARS, hold; recent price, $51), the index also got a lift from gains in big military weapons makers such as Lockheed Martin (LMT

; 2 STARS, sell; $53) and Northrop Grumman (NOC

; 1 STARS, strong sell; $53).

But the best days may be behind the big defense names. Our valuation models continue to indicate that most are trading at high multiples to our estimates of sustainable cash-earnings growth and return on equity (ROE). So we believe that most defense industry stocks still sell at large premiums to estimated intrinsic value.

A LID ON R&D. Despite ongoing military action in the Middle East, we believe the U.S. military procurement and R&D budgets will grow at modest -- but sustainable -- rates. We believe sluggish growth in tax receipts, as well as political pressures to balance budgets, bolster huge federal entitlement programs, and fund homeland security and overseas peacekeeping initiatives, will likely prevent the procurement and R&D sectors of the U.S. military budget from expanding at a long-term annual rate greater than 4%.

As it appears America's main adversaries are utilizing small, scattered terrorist cells as the primary means of warfare, influential figures in the Pentagon, including Defense Secretary Donald Rumsfeld, have questioned the need to maintain huge arsenals of traditional weapons systems such as fighter planes, tanks, and ships. Given all the factors mentioned above, we believe the Pentagon will be forced to cut back on traditional weapons such as Lockheed's F-22 fighter jets and Northrop's destroyers and aircraft carriers.

Hence, we think defense stocks such as Northrop, Lockheed, and EDO Corp. (EDO

; 2 STARS; $29) are overvalued, which is why we maintain either sell or strong sell recommendations on them. Our 12-month target prices are $40 for Northrop, $50 for Lockheed, and $25 for EDO.

Required Disclosures

5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of September 30, 2004, SPIAS and their U.S. research analysts have recommended 29.2% of issuers with buy recommendations, 58.5% with hold recommendations and 12.3% with sell recommendations.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, New York, NY 10041.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.


This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Analyst Friedman follows aerospace and defense stocks for Standard & Poors Equity Research Services

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